QE2 101: How the Federal Reserve managed to print money

Ordinarily, the Fed changes interest rates and the Treasury prints money. But with interest rates near zero, the Fed looked for a new strategy to make loans attractive.

Everyone is singing the praises of the Federal Reserve’s next round of “Quantitative Easing” to the tune of nearly $1 trillion. Those in favor extol the virtues of the magical printing presses as if we all had been given a free cruise on the ship Queen Elizabeth 2. The truth for most of us is closer to 3rd class tickets on the Titanic.

Quantitative easing is simply printing more money. Normally the Federal Reserve buys government bonds passively to maintain its interest-rate target. With quantitative easing the Fed aggressively buys government bonds and other securities in large quantities.

So how does the Federal Reserve print money? First, it buys government bonds and other financial securities from big New York City banks. It pays for these bonds with newly created electronic money, using computers to change the records of the banks’ accounts at the Fed. If the banks want paper dollars, Federal Reserve Notes, the Department of the Mint at the U.S. Treasury prints and sends crisp new dollars to the Federal Reserve which forwards them to the banks.

People with inside information, or well-informed guesses can make tons of money off this process. Some bond traders and big banks are making a killing off of QE2.

The Fed says that quantitative easing will reduce interest rates and that this will increase investment spending which will increase employment and therefore help the economy recover. The truth is different. Printing money only distorts markets and slows the recovery as capital is again misallocated as was the case in the housing bubble and the tech bubble before it. Remember that Chairman Bernanke told us from 2005 to 2007 that there was no housing bubble and that everything was fine.

In addition to the threat of new bubbles, there is the more immediate and visible threat of price inflation. The value of the dollar has fallen by 13% over the last 5 months. The September Producer Price Index showed that meat prices went up 5.2% and gas went up 6.1%. Meanwhile, interest rates are at historically low levels; for retirees and savers this has virtually eliminated safe interest income and forced people into more risky assets.

Basic economics tells us that any set amount of money is sufficient as long as prices and the value of money are free to adjust. Given all the Fed’s money printing we should not be surprised that gold is up 24% this year. The reason the price fluctuates is that the value of the dollar is fluctuating, in this case plummeting, not that gold is unstable.

Quantitative easing is just printing money. This cannot help the economy recover and in many ways makes the economy and the dollar more unstable. It certainly is a bad deal for consumers, retirees and savers. The only beneficiaries are large multinational exporters, dealers in government bonds and securities, and money managers with inside information. Economic recovery will occur not because of quantitative easing, but in spite of it.

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